Here's why negative interest rates could be heading even lower

LimboPaul L Dineen / Flickr, CCThis kid can go pretty low.

Several central banks around the world have taken interest rates into negative territory.

Theoretically, negative interest rates are supposed to boost economic activity by encouraging lending from banks who are now charged some amount to park their money at the central bank.

Market reaction to this policy, however, has not been kind.

But since the negative interest rate policy is pretty unconventional — and with about one-fifth of the world’s GDP currently covered by negative rates — investors have a lot of questions.

Specifically, many are wondering how low can negative rates actually go? And why?

Goldman Sachs’ Japan team led by Naohiko Baba addressed this question in a recent note to clients.

Theoretically, the net rate of return on cash holdings (zero minus holding costs) becomes a floor for negative interest rates,” the team wrote.

Nominal interest rates hitting zero has been viewed as a floor for rates, which as Baba’s team notes is in part because people would look for arbitrage opportunities by transferring funds from interest rate products to cash in the event that nominal rates fell below zero.

However, that thinking ignores the costs associated with holding cash.

Here’s Goldman (emphasis ours):

“First, a highly secure storage facility is needed to hold large amounts of cash safely, resulting in some fixed costs. Some variable costs are also needed for things like security, transportation (to move the cash to the secure facility) and insurance. Also, when shifting to cash, some of the convenience that comes with using a settlement system linked to deposits may be lost. This too can be viewed as a cost, albeit one that is difficult to quantify. Because the gross nominal rate of return on cash is zero, the net nominal rate of return deducting these costs becomes negative. In short, theoretically speaking, interest rates can be lowered to the same level as the net rate of return on cash.”

Said another way, if cutting rates into negative territory would compel someone to put their cash under a mattress, rates can go as low as possible so long as the charge for keeping that cash in the bank doesn’t exceed the cost of the bed.

Additionally, markets aren’t exactly loving negative rates, however, with Business Insider’s Matt Turner reporting earlier this week that Wall Street has two big fears:

  1. Negative rates will hurt banks by eroding a key measure of bank earnings called net interest margin, which is the difference between what banks get paid by borrowers and what they pay for deposits.
  2. Some people think that the decision to go negative is a sign a central bank’s policy isn’t working.

Moreover, some analysts have noted negative rates have not exactly achieved their intended goal so far.

Earlier this week Business Insider Australia’s David Scutt cited a team at Bank of America Merrill Lynch which noted that in the month after the adoption of negative interest rate policy (or NIRP), currency weakness, increased inflation expectations, and gains in stock markets have — by and large — not eventuated in most instances.

But on Thursday global markets ostensibly got a sign that Sweden’s experiment with negative rates could actually be working.

Sweden’s Riksbank showed in its monthly report that inflation ticked up to 0.8% (besting forecasts for a 0.5% increase) for the first time in more than a year.

This figure was higher than at any point since 2012, although we would be remiss if we did not note that Sweden is also looking at other huge problems associated with the negative rates policy.

Most recently, the Bank of Japan launched negative rates in late January, putting the rate on some deposits at -0.1%.

Bank of Japan governor Haruhiko Kuroda stated that the bank can (and will) cut rates deeper into negative territory if they need to.

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